Class 2 role of finance in development 2018

Development Finance, MPP, VJUProf. K. Fujimoto

Class 2 Role of Finance in Development1. Roles of the Financial System(1) Definition of “Finance in Development”Finance in Development can be defined as a “Financial System at Large.” Thefinancial system does, therefore, encompass financial markets (e.g. money market),financial institutions (e.g. banks), and financial policies and related policy measuresas a whole.(2) Three Functions of the Financial System(i) Settlement Function or Administering the Country’s Payments MechanismThis function permits that, through a bank’s A/C, buyers and sellers can settle thetransaction of commodities without handling cash, which implies less risk andless trouble.(ii) Intermediation Function or Intermediating between Savers and InvestorsIn the financial system, funds flow from those who have surplus funds to those whohave a shortage of funds, either by direct, market-based financing or byindirect, bank-based finance.(iii) Function to Provide Stages Where a Variety of Economic Policies are ExercisedVia the financial system, various economic policies are exercised. Some of these are

the monetary policy vis-à-vis the price stabilization policy, the foreign exchangepolicy and the industrial policy vis-à-vis the credit rationing/incentive interestpolicy.These functions prevail not only within developed countries but also developingcountries.2. Economic Development and the Financial System(1) Financial Repression and Keynesian Economics (From 1945 through the Middle ofthe 1970s)(i) Why the repression policy was widely accepted and exercised?Financial repression consists of various measures, such as interest rate ceilings, highbank reserve requirements, liquidity ratio requirements, government directives onthe directions of credit and so forth. And policies of financial repression wereexercised between 1945 to the middle of the 1970’s.There are two fundamental reasons why the repression policy was widely

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Development Finance, MPP, VJUProf. K. Fujimoto

supported and exercised during this period. (a) Keynesian economics which ischaracterized as economics of effective demand to which government interventionsare regarded essential and (b) central planning economies of the socialist countrieswere experiencing a relatively successful economic growth. Thus, the role ofgovernment was well regarded as an intervening measure to manage economicgrowth.(ii) Components (policy measures) of the repression policya. Interest rate ceilingsInterest rate ceilings are set deliberately below the competitive free marketequilibrium rate of interest so that credit can be allocated on non-price criteria.In this way, the private sector can be encouraged to undertake the centrallyplanned investment even though those projects might well be unprofitable at themarket interest rate. For instance, the loan interest rate ceilings have been usedin conjunction with import restrictions to encourage industrialization throughimport substitution (an industrial development policy).Structuralists and neo-structuralists insist that raising interest rates increasesinflation in the short run through a cost-push effect and lowers the rate ofeconomic growth at the same time by reducing the supply of credit in real termsavailable to finance investment. Thus, their models (of, say, interest rate

ceilings) provide an intellectual justification for financial repression.Governments often impose a ceiling on the interest rate that banks can offerto depositors. Interest ceilings function in the same way as price controls, andthereby provide banks with economic rents. These rents benefit the incumbentbanks and provide tax sources for the government, paid for by savers andborrowers.b. High bank reserve requirementsHigh bank reserve requirements are another policy measure of financialrepression. A bank must hold cash in reserve against deposits made becustomers, which is usually kept in the central bank. Governments requirebanks to meet high reserve ratios, and use the reserves as a method to generaterevenues. Because reserves do not earn interests, reserve requirements functionas an implicit tax on banks and also restrict banks from allocating a certainportion of their portfolios to investments and loans. Consequently, the high bankreserve requirements reduce the money supply in the economy and result ininterest rate hike. Thus, the reserve requirements have fiscal as well asmonetary implication.2

Development Finance, MPP, VJUProf. K. Fujimoto

c. Liquidity ratio requirements

A variant of the reserve requirements includes required liquidity ratio whichrefers to highly liquid assets held by banks to meet short-term obligations. Forinstance, banks are required to allocate a certain fraction of their deposits toholding government securities that usually yield a return lower than could beobtained in the market. Another fiscal implication as a source of governmentrevenue.d. Government directives on the direction of creditFinancial repression also takes the form of government directives for banks toallocate credit at subsidized rates to specific firms and industries to implementindustrial policy. Government directives and guidance sometimes includedetailed orders and instructions on managerial issues of financial institutions toensure that their behavior and business is in line with industrial policy or othergovernment policies.(iii) Fiscal implication of financial repressionIn practice and reality, however, the predominant rationale for financial repressionlies in its fiscal implications. Interpreted as a discriminatory tax on the financialintermediation, financial repression comprises high reserve requirements, liquidityratio requirements, interest rate ceilings and government directives on the directionof credit and exchange controls. This implies that, if institutional constraintsprevent the government from collecting adequate normal tax revenue to financethe level of government expenditure it regards as optimal, financial repression maybe justified as a second-best strategy.The combined effect of the above financial repression measures implies that thegovernment can funnel funds to itself without going through legislative proceduresand more cheaply than it could when it resorts to market financing.The financial repression policy is meant to make more use of the third function,namely, “stages where various economic policies are practiced” within the financialsystem.(2) McKinnon-Shaw (Ronald I. McKinnon and Edward S. Shaw) Model and FinancialLiberalization (~From the Middle of 1970s through the Early 1980s~)The financial repression measures described above, which are often introduced underfiscal exigencies, reduce the incentive to hold money and other financial assets, andso reduce the overall availability of loanable funds to investors. Not only may the3

Development Finance, MPP, VJUProf. K. Fujimoto

credit shortage encourage more low-yielding self-financed investment, but lowsubsidized interest rates to priority borrowers may also reduce the average return oncredit-financed investment.The McKinnon-Shaw model formalizes these ideas, showing that financialrepression reduced both the quantity and the quality of investment in the economy asa whole. The McKinnon and Shaw model, thus, advocates financial liberalizationwhich allows market forces to determine the rate of interest -the model postulatesthat as interest rates rise towards competitive equilibrium, it will have a positiveeffect on savings and investment. This leads to the efficient allocation of capital,which perpetuate the development process or economic growth. Since 1973 theMcKinnon-Shaw financial liberalization paradigm has exerted considerableinfluence on macroeconomic policy in developing countries, particularly throughthe recommendations of the IMF and the World Bank.McKinnon also pointed out that financial repression encourages economic dualism,while Krugman (Paul Robin) shows that financial repression can worsen incomedistribution, but need not necessarily cause economic dualism. However, Galbisshowed that financial repression not only worsens income distribution but alsomaintains economic dualism.The financial liberalization policy is meant to make more use of the secondfunction, namely, “intermediation function” within the financial system.⇒ McKinnon’s Model⇒ Shaw’s Model(See Maxwell J. Fry, Money, Interest, and Banking in Economic Development, 1995and Emancipating the Banking System and Development Markets for GovernmentDebt, 19)(3) The Financial and Banking Crisis ~1982 onwards~(i) Banking Crises Experienced in the PastAlthough the financial liberalization policy was pursued since the mid-1970s, quitea number of developed and developing countries experienced banking crises.According to an IMF survey, 133 countries out of 181 member countriesexperienced serious banking crises from 1980 through the late 1990s. Suchproliferation of large-scale banking sector problems has raised widespread concern,as banking crises disrupt the flow of credit to enterprises and households, reducinginvestment and consumption and possibly forcing viable firms into bankruptcy. A4

Development Finance, MPP, VJUProf. K. Fujimoto

banking crisis may also jeopardize the functioning of the payments system and, byundermining confidence in domestic financial institutions, they may cause adecline in domestic savings and/or a large-scale capital outflow. Finally, a systemiccrisis may force sound banks to close their doors.The definition of a banking crisis may be as follows: Financial Distress: “when a significant fraction of the banking sector is insolventbut remains open” Financial Panic: “when bank debt holders suddenly demand that banks convert

their debt claims into cash to the extent that the banks are forcedto suspend the convertibility of their debt into cash”The four indicators below may define a banking crisis more objectively andsystemically.- Non-performing loans occupy at least 10% of total assets.- Cost of rescue operations is more than 2% of GDP.- Banking problems result in largescale nationalization of banks.- Emergency measures, such as deposit freeze, prolonged bank holidays,generalized deposit guarantees are introduced.(ii) Causes of Banking CrisesThe causes of banking crises can be divided into two categories: microeconomicones (bank specific or bad banking), and macroeconomic ones (bad operationalenvironment).a. Microeconomic/Bad Banking FactorsA banking crisis often has its roots in poor bank operations including one of evenpossibly more of the following: poor lending practices, excessive risk taking,poor governance, lack of internal controls, focus on market share rather thanprofitability, and currency and maturity mismatches in the banks themselves oramong their borrowers.b. Macroeconomic/Bad Operating Environment FactorsA banking crisis can arise from macroeconomic causes that are external to thebanking system as well. Even a well-run banking system operating in a stronglegal and regulatory framework can be overwhelmed by the effects of a poormacroeconomic environment against inadequate policies. Macroeconomicdifficulties may arise from lending booms, possibly stoked by excessive capitalinflows or changes in tax rules; real estate and/or equity price bubbles that5

Development Finance, MPP, VJUProf. K. Fujimoto

inflate and burst; slowdown in growth and/or exports, or the loss of exportmarkets; growing excess capital/falling profitability in real sector; lower overallinvestment; rising fiscal and/or current account deficits; weakened public debtsustainability; sharp changes in exchange rates and real interest rates; and so on.Not all of these developments are under the control of the authorities butgovernments must be ready to adapt macro policies that take the conditions of asystematically distressed banking system into account.(See Speech Manuscript of Mr. Stefan Ingves, Director of IMF, delivered onApril 8, 2003 in Buenos Aires)(iii) Sequential Responses to Banking Crises by the Banking Authoritiesa. A Ten Step ApproachSteps 1 to 4. The acute crisis phase: measures to stop the panic and stabilize system.Step 1. The crisis usually begins because, in one form or another, there isexcessive leverage in the economy. In the early stages there mayalso be a degree of denial on the part of the banks and thegovernment.Step 2. Bank runs by creditors and depositors start and intensify. The central bankresponds by providing liquidity support to the affected banks.Step 3. When central bank liquidity is unable to stop the runs, the governmentannounces a blanket guarantee for depositors and creditors. Such ameasure is intended to reduce uncertainty and to allow time for thegovernment to begin an orderly restructuring process.Step 4. All along, the central bank tries to sterilize its liquidity support to avoid aloss of monetary control.Steps 5 to 8. The stabilization phase: measures to restructure the systemStep 5. The authorities design the tools needed for a comprehensive restructuring,including the required legal, financial, and institutional framework.Step 6. Losses in individual institutions are recognized. The authorities shift thefocus from liquidity support to solvency support.Step 7. The authorities design a financial sector restructuring strategy, based on avision for the post-crisis structure of the sector.Step 8. Viable banks are recapitalized, bad assets are dealt with, and prudentialsupervision and regulations are tightened.Steps 9 to 10. The recovery phase: measures to normalize the system.6

Development Finance, MPP, VJUProf. K. Fujimoto

Step 9. Nationalized banks are re-privatized, corporate debt is restructured, andbad assets are sold.Step 10. The blanket guarantee is revoked, which, if properly handled, is anonevent because the banking system has been recapitalized and ishealthy again.(See Carl-Johan Lindgren and Others (1999), Financial Sector Crisis andRestructuring: Lessons from Asia, IMF Occasional Paper No. 188.)b. Short-term and Long-term ApproachShort-term Responses:In order to prevent the financial/banking system from collapsing, macroeconomicas well as bank-specific responses are required. In case that a currencycrisis is involved, a comprehensive macro stabilization policy whoseformulation and implementation are supported by IMF has to beimplemented. In this case, therefore, the banking crisis has to be taken careof within the macroeconomic stabilization policy.Bank-specific responses include interest rate increase(s) to absorb liquidity andprevent capital flight, liquidity supply and blanket guarantee (together withdeposit insurance organizations, if any) to restructure banking institutions(suspension, nationalization, closure, and so on).Long-term Responses:Bank’s Corporate Governance; banks are required to pursue accountableand transparent management. One of the measures would be theintroduction of new accounting rules and regulations vis-à-visevaluating land and other assets values, reflecting risks of foreignexchange fluctuations and so on.Prudential Regulations; prudential regulations cover factors such asCapital adequacy, Asset quality, Management ability, Earnings andLiquidity (CAMEL in short). Through strengthening these factors,banks upgrade their soundness.Strengthening the Bank Inspection Capacity of the Banking Authorities;the banking authorities must acquire knowledge and the expertise tosupervise banks on and off site. Promotion of Sound Competition among Banks and Pursuance of Selfresponsible Management; the banking authorities must introduceeffective policy measures to promote competition among banks andestablish objective and clear criteria to suspend, transfer or liquidate7

Development Finance, MPP, VJUProf. K. Fujimoto

banks upon their performances.(iv) Costs of Instability in the Banking SystemAccording to empirical research, the costs of banking crises measured in terms offiscal expenditure tend to be larger in lower-income countries and those withhigher degrees of banking intermediation. Countries with large fiscal costs ofcrisis have in the past often experienced a simultaneous currency crisis,especially those that had in place a fixed exchange rate regime. Further, theoutput losses that incurred during the crisis period are large, 15% to 29% onaverage of the annual GDP. Output losses are usually much larger in the event ofa twin banking/currency crisis than if there is only a banking crisis, particularlyin emerging market countries.(See Hoggarth, Glenn and Others (2001), Costs of banking system instability:some empirical evidence, Working Paper, Bank of England)3. Economic Development and Capital Fund FlowsIn view that external capital fund inflow into developing countries plays an importantrole in their economic growth, let us review how economic growth of developingcountries has been supported by the capital funds of developed countries. (Figure 1)(1) From 1945 to First Oil Crisis of 1973During this period, capital funds were supplied mostly by the governments ofdeveloped countries in the form of ODA and multilateral development banks(MDBs) such as the World Bank and the IMF. Fund flows by international privatecommercial banks into developing countries (Private Flows) were quite limitedduring this period. As the terms and conditions of the loan funds provided by thedeveloped countries and MDBs were quite soft, there was little risk of foreign debtaccumulation during this period on the part of LDCs.Thus, this was the period when government or public sector played the crucial rolein supplying most of required capital funds of development of the Third World.This period coincides with Keynesian financial repression.(2) From the First Oil Crisis (1973) to the Late 1980sDuring this period huge amount of oil dollars circulated, through internationalcommercial banks of the developed countries, into non-oil-producing LDCs. Theterms and conditions of these loan funds were quite harsh (dollar denominatedvariable interest rates) in comparison with ODA. This is the age of “ODA + PF” inthe 1980s’ with strong dollar and high interest rates that deteriorated the B/P8

Development Finance, MPP, VJUProf. K. Fujimoto

conditions of LDCs and the second oil crisis of 1978/79 triggered to surface thedebt crisis of quite a number of non-oil-producing LDCs. In 1982, Mexico declared“default” as the first moratorium country.Thus, this was the period when capital fund for development had increasingly beensupplied through private sector market. This period coincides with McKinnonShaw’s financial liberalization. However, multiple banking crises emergedcontinuously during the ‘80s and ‘90s.(3) Late 1980s and onwardsIn addition to FDI, portfolio investment to LDCs considerably increased during thisperiod. In this connection, institutional investors of developed countries (InsuranceCompanies, Pension Funds, Investment Trust Funds and so on) played the centralrole. On the other hand, both the developed and developing countries have jointlystarted to work to establish a sound, accountable and transparent financial systemwithin the LDCs.4. Lessons Learned(1) Regarding Financial Repression PolicyKeynesian economics reviews economic growth on the basis that macro savingsequals macro investment. However, it misses or does not explain the processes onhow savings turn into investment. In other words, the financial repression policydid not take into account of the intermediation function which was then left in ablack box. As a result, the financial repression policy was justified andimplemented without scrutinizing the grand picture of the sound financial systemdevelopment as a whole.(2) Regarding the Financial Liberalization PolicyOn the other hand, the financial liberalization policy placed exclusive and excessiveimportance on the intermediation function of the financial system. It then did notpay adequate attention to risks involved in the settlement function. Further, it wasassumed that the financial liberalization would bring about a well-functioningoptimal financial market through its market mechanism and did not take necessarypre-cautious measures to prevent market failures such as the moral hazard case. Asa result, it can be said that thus the banking crises occurred during the ‘80s and’90s.

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Development Finance, MPP, VJUProf. K. Fujimoto

Generally speaking, economic theories are constructed on selected influentialassumptions. If policies are formulated and exercised without fully understanding thelimitations of those theory assumptions, they tend to result in serious consequences.In formulating and implementing policies, one should not forget that they mustcontinuously be scrutinized from a comprehensive point of view.Figure 1 Capital Fund Flows to Developing CountriesSource: DAC